Monday, December 29, 2008

Fair Value, Mark-To-Market and Financial Reporting-Another Revision?

Less than a week to go for 2008, and the Financial Accounting Standards Board (FASB) has a proposal which it has thrown into the arena to address the problem of fair value.

Mark to market accounting has stirred up a very ugly debate between its adversaries and its proponents. Mark Sunshine, in a Seeking Alpha post some months ago noted that: " Mark to market rules distort financial results and business decisions under the false cloak of conservatism. The rules make little sense, produce inconsistent results, lack a basis in reality and provide lots of room for abuse." Other prominent naysayers as far as the current accounting rules for mark-to-market include Steve Forbes and noted fund manager, Ron Muhlenkamp.Here is a recent interview where they discuss mark-to-market accounting.Forbes does not mince his words:

"Henry Paulson is the worst treasury secretary in living memory. But even though he's miserably mishandled this financial crisis there's still time for him to turn things around. He can--somewhat--repair his reputation. He simply needs to back away from the disastrous policies and practices that have defined his tenure."

"His first mistake was to support the weak-dollar policy that sparked and fed the crisis. Then he continued to enforce mark-to-market accounting rules. Mark to market destroyed bank balance sheets. Now insurance firms are faltering under its weight. But there's still time for common sense...And while mark to market is fine for publicly traded stocks, it makes no sense when you don't have a market, as with packages of subprime loans. And it also makes no sense for long-term insurance reserves. Paulson and the SEC can suspend this inane rule in a heartbeat, yet they refuse. Adhering to one position without regard to consequences and expecting a different result is the definition of insanity. It's time for Paulson to follow the path of reason."
Proponents of mark-to-market generally perceive greater transparency with its usage. For example, here is a part of a letter to FASB by Rebecca McEnally of the Investors Technical Advisory Committee (IATC):

"The ITAC believes that it is especially critical that fair value information be available to capital providers and other users of financial statements in periods of market turmoil accompanied by liquidity crunches such as we're now experiencing. In the absence of timely fair value information, uncertainty increases, further exacerbating market instability and causing investors to withhold investable funds or demand a hefty uncertainty premium. A cornerstone of the restoration of investor confidence must be to provide the information investors need to make risk-based decisions."

"Regulators recognize that fair value measurement is an essential tool in their oversight and monitoring of the risk management practices and risk profiles of financial institutions, and ensuring that the institutions' capital provisions are adequate to support the risks embedded in the financial instruments and other assets the institutions hold and the financing used to support those assets. Given this widely-recognized critical importance of providing relevant, high-quality financial information to the markets, the ITAC has been dismayed to learn that a few managers of major financial institutions, along with representatives of industry organizations representing some financial institutions, are now calling for a suspension of fair value reporting for financial instruments. They argue, in effect, for a return to the old financial reporting model for financial instruments in effect decades ago with its out- of-date historical cost reporting and lack of transparency, particularly for embedded financial risks."

The proponents credit the transparency they believe that mark-to-market has brought to capital markets with the market's improved understanding of the risks and consequent selling off of many financial services stocks.

"Recently, some have attempted to shift the blame for the current crisis from the poor business and investment decision-making, including the flawed underwriting, securitization, risk management, and disclosure practices in which they engaged, to fair value financial reporting, a "shoot the messenger" argument. This reasoning is both perplexing and misleading. In fact, the current requirement to report financial instruments at fair values was instrumental in the uncovering of the deep and widespread problems in the markets. The long-term solution to the problems relies heavily on the retention of the requirement to provide fair value information to investors and regulators: the higher the quality of fair value information that is provided, the faster will be the necessary market adjustments to the problems."
"What those making the argument fail to recognize is that these are not abnormal features of the measurements, per se, but rather characteristics of the normal functioning of markets as investors reassess risks and rewards and liquidity disappears for poor quality securities and investments with little transparency. Some downward price revisions will inevitably result in the triggering of covenants that the original purchasers of securities or lenders demanded as a condition of investing in the securities and agreeing to the terms upon which the capital was provided to issuers. Again, these triggers are a normal part of the contracting process and designed to protect the investors, including lenders. The fact that the triggers were activated is not an indictment of the measurement system but rather is a direct function of the poor or deteriorating quality of the investments. Arguing that by not recognizing the poor or deteriorating quality of the investments we will somehow solve the problem is not only inappropriate but is a variant of the "shoot the messenger" argument: Pull the covers over the problems and maybe they will just go away."
I certainly recognize that under most normal circumstances, there is great transparency in fair value as opposed to other methodologies. However, it is also very clear to me that a myopic and complete focus on fair value can in effect be liquidation or bankruptcy value in times of severe systemic stress. I would agree with Forbes that the triggering of covenants that has resulted from large and probably unnecessary write-downs has caused more panic than elucidation as far as asset values. As he said very colorfully:

"Also of immediate urgency is for regulators to suspend any mark-to-market rules for long-term assets. Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline."

A compromise of sorts appears to be coming. The FASB would like firms to include in their financial statements a table which provides a comparison of three different reporting measurements:
  1. The reported carrying value
  2. Fair Value
  3. Incurred Loss Amount

These changes would allow managements to highlight future cash flows of securities that will be held to maturity and are available for sale. Though the near term "fair value" or "market value" in a very constrained and illiquid market may look dreadful, the majority of many of these assets will likely pay off over their long term maturity. Hence, the "incurred loss" category when it demonstrates that few losses have actually been incurred may create some substantiation of long term value that is more realistic in my opinion than what we have now.

This proposal labelled proposal FAS 107-a, if approved, would go into immediate effect for reporting periods after December 15th, 2008! That puts more than a little uncertainty into forecasts of fourth quarter financial services profit forecasts. But at least the uncertainty may be somewhat positively skewed in favor of less write-down in the recognition of "fair value."

Part of the backbone of accounting is what's known as the conceptual framework which describes the function and purpose of accounting. As the FASB and the global body, the IASC consider a new conceptual framework, they propose (italics are mine):

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. Capital providers are the primary users of financial reporting. To accomplish the objective, financial reports should communicate information about an entity’s economic resources, claims to those resources, and the transactions and other events and circumstances that change them. The degree to which that financial information is useful will depend on its qualitative characteristics.

Financial reporting information is a faithful representation if it depicts the substance of an economic phenomenon completely, neutrally, and without material error. It must also be relevant.

In my view, the substance of financial reporting should focus on the long term substance of the transaction rather than the strains of the current capital market. Perhaps the new proposal begins to address the situation. Perhaps what is sacrificed in terms of timeliness and verifiability is offset by improvements in comparability and relevance.

Unfortunately, forecasting results will become even more difficult as accounting rules may be modified at the worst possible time, the year-end for most companies. But, if implemented, these rules may provide a bit of sunshine and upside at long last to a sector that has been wrapped in uncertainty and fear if not deprived of common sense for some time.


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